How the IRA Early-Withdrawal Penalty Works
Here’s an example to show how the early-withdrawal penalty works. Suppose you are age 54, and you take $10,000 from your traditional IRA. The penalty would be calculated as follows:
The $10,000 would be considered income on your tax return. This income would be included along with your other sources of income to determine the total amount of tax owed for the year. The amount of tax owed on the $10,000 would depend on your income tax rate, which is determined by your total income and deductions. In addition to the tax on the $10,000 early withdrawal, a 10% penalty would be assessed on the withdrawal. In this scenario, that would be an additional $1,000 of tax owed, in addition to the increase in your ordinary income taxes due to the additional $10,000 in income.
If you didn’t pay enough during the year, you could owe at tax time, and you could also be hit with an additional penalty from the IRS for underpayment of taxes. To avoid that, when you take your IRA distribution, it is best to have taxes withheld right from the distribution. So if you were taking a $10,000 early distribution, and had 30% in taxes withheld, you would receive a check for $7,000, and $3,000 would get sent right to the IRS for taxes.
Avoiding the Early-Withdrawal Penalty
If you are using an early IRA distribution to pay off debts and avoid potential judgments, think again. Retirement accounts may provide some forms of creditor protection. Many of the creditor-protection rules that apply to 401(k)s also apply to IRAs. It is tough to save enough to replenish an account after an early withdrawal. You should think of your IRA money as your nest egg. Do everything you can to avoid an early withdrawal. If you have to take funds from your IRA, see if you can qualify for an exception to the early-withdrawal penalty. The early-withdrawal penalty above also applies to early withdrawals taken from 401(k) accounts. Once you reach age 59 1/2 (or age 55 in some cases for a 401(k) plan), the penalty will no longer apply to withdrawals. At that point, any withdrawal becomes ordinary taxable income to you.
Opportunity Costs
The penalty and taxes may not seem that steep at first, but remember, that same $11,000 today would be worth $26,000 15 years down the road if your investments earned 6% annually. Ask yourself, is this my best option? Is it worth the steep tax penalty? What other decisions have I made this year that might impact my taxes? In most cases, it’s best to leave your IRA alone if at all possible.
